Europe’s strengthening economy and political stability are catching the stock market’s attention.
In June, the European Central Bank raised its eurozone growth forecast to 1.9 percent for this year from 1.8 percent in March and also boosted its 2018 and 2019 growth outlooks. Meanwhile, the Eurostat statistics agency said first-quarter economic growth in the region was the fastest in a year, according to the BBC.
Add to that the election of political centrists in the Netherlands and France, along with the likelihood that German Chancellor Angela Merkel will be reelected later this year, and more financial market watchers see positive signs in Europe.
[See: 10 Smart-Beta ETFs That Will Help You Get Your Alpha.]
Before the Dutch and French elections, there was the possibility of the Netherlands and France leaving the eurozone, says Peter Andersen, chief investment officer at Fiduciary Trust Company in Boston. “We have two out of three elections down, and we have more clarity with the German chancellor election. It looks like Merkel is highly likely to be reelected,” he says. “That promotes increased stability in the eurozone.”
That newfound confidence is showing up in the returns of the major European stock indexes, which are outperforming U.S. equities. So far this year, two popular pan-market European exchange-traded funds, the iShares Core MSCI Europe ETF (ticker: IEUR) and Vanguard FTSE Europe ETF ( VGK), are up 16.82 percent and 16.98 percent, respectively. By comparison, the benchmark U.S. index ETF, SPDR Standard & Poor’s 500 index ETF ( SPY), is up a lackluster 9.78 percent.
Because three- and five-year returns of European equities have lagged the S&P 500 index, this year’s outperformance could just be the Europeans playing catch up, but market watchers say it may be the start of continued equity growth in the region.
Still, investors should be selective because the outlook is rosier for some parts of Europe than others.
U.K. woes deepen. In fact, the biggest dividing line may be the English Channel.
“What we are very positive on is specifically the eurozone,” says Erik Esselink, portfolio manager for Invesco Global Core Equity Strategies in Atlanta. “That excludes the U.K., where we’re pretty negative, actually.”
Britain’s vote to leave the European Union last year, a decision known as Brexit, has hurt the U.K. more than Europe, even though the divorce hasn’t officially started.
The recent French elections aren’t helping Britain’s negotiating prospects, either. Newly elected French president Emmanuel Macron is already working closely with Merkel, notes Brian Beitner, managing partner and chief executive officer at Chautauqua Capital Management, a division of Baird in Boulder, Colorado.
“While there are no immediate investment implications, Macron’s early strategizing with Merkel is momentous,” Beitner says. He believes “further Franco-German economic integration” will weaken the United Kingdom’s position to negotiate a favorable new trade agreement with the eurozone.
[Read: 9 Ways to Invest in British Stocks, Despite Brexit.]
Stick to the eurozone. Switzerland and the Scandinavian countries, which, like Britain, are not part of the euro, have good prospects but the shares are expensive, Esselink says. “Where we see the most opportunity is in the eurozone itself and specifically countries like France, Benelux (Belgium, Netherlands, Luxembourg), Italy and Spain,” he says.
Esselink is optimistic about eurozone equities for two reasons. First, other investment alternatives — eurozone fixed income and real estate — continue to have low yields. Second, the outlook for European corporations is positive. Financing costs remain low because of the European Central Bank’s continued quantitative easing policies. Plus, structural reforms that make it easier to hire and fire workers in countries like Italy, France and Spain, and changes to corporate tax rates are helping companies become more competitive.
“The way it manifests itself, margins in Europe are still in an upward trajectory, where in places like the U.S., we think margins have peaked in the cycle,” he says.
In a June global outlook research note, Barclays analysts suggest investors overweight European equities, even with the strong year-to-date performance. “Europe remains our top regional pick. Despite recent outperformance, European equities still trade at a discount to the U.S. of roughly three times earnings,” the analysts note.
With earnings rebounding as the economy improves, the Barclays analysts believe there’s more room for growth, and Beitner says, “All things being equal, the stocks of European companies that operate in the region should be afforded higher valuation multiples because the economy there should be less volatile.”
Small caps’ big benefit. Invesco’s global core and international equity funds, which overweight European stocks, also invest long term in small and mid-size European companies in part for the faster growth that smaller companies typically offer, Esselink says.
But he also notes eurozone small-cap stocks are not trading in sync with the fixed-income market, while large cap stocks increasingly do. As a rule, stocks and bonds should not trade in lockstep, which reduces the diversification benefits of investing in both.
The benefit of small-cap stocks, which continue to offer diversification from fixed income, will be even more apparent when bond yields increase and bond prices fall, which will happen eventually as interest rates rise.
Of the few European small-cap funds that exist, WisdomTree Europe SmallCap Dividend Fund ( DFE) and iShares MSCI Europe Small-Cap ETF ( IEUS) rank among the largest in the category based on assets under management. Both have similar returns, with the iShares fund returning 19.81 percent year-to-date compared to the WisdomTree fund’s 19.33 percent. While the latter has a 0.58 percent expense ratio, or $58 per $10,000 invested, the iShares MSCI Europe Small-Cap’s is 0.40 percent, or $40 per $10,000 invested.
[See: The 10 Best European Stock ETFs on the Market.]
Andersen’s firm is more cautious and still underweights Europe even as it increases exposure to the region.
Although Europe’s uncertainty is fading, Andersen says, Brexit is still a looming possibility that could have negative effects on the continent.
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The Market Takes a Shine to Europe originally appeared on usnews.com
